The Automated Edge: Diversification in the Futures Market

Futures markets move quickly, leaving traders to make split-second decisions in response to market shifts. Fortunately, there is a trading ally that can simplify this process—one that never sleeps, gets emotional, or second-guesses decisions. Automated trading systems offer innovation and opportunity, whether you’re an active trader, new to trading or in between. But is implementing these systems the right move for you? Let’s dive into automated trading systems and discover how these systems can impact your trading approach. 

What is an automated trading system?

Simply put, an automated trading system is a program that executes trades automatically based on certain predefined criteria. 

Automated systems and programs have existed for quite some time, even before the advent of modern computing power. As technology has progressed, including the introduction of electronic trading, automated programs have become ubiquitous.  Today, large HFT (High Frequency Trading) firms employ more quants and developers than people you might consider traditional “traders.”  Automation is also used by CTA’s (Commodity Trading Advisors) allowing the CTA to potentially manage more trades, markets, and products without the traditional discretionary inputs. 

In futures markets, these systems can run nonstop while the market is open, constantly seeking trade opportunities and, depending on the level of sophistication, executing on multiple markets, products, and timeframes. Outside of highly sophisticated and well-funded firms managing large amounts of capital, there are other providers and brokers, like EdgeClear, that offer automated trading systems and programs with lower barriers of entry. This means, you may not need to have several million dollars lying around to get access. These lower barriers of entry can offer a self-directed trader or investor a way to diversify in the futures market.  Of course, that is if you know how to differentiate the professionals from the “snake oil” salesman. Rule of thumb, if it sounds too good to be true, it probably is, more on that later.

Why Use Automated Trading?

Consistency

Automated programs execute based on algorithms, which can help eliminate emotional decision making and ensure the consistent application of a trading strategy—barring any technical glitches. It is human nature to want to protect against losses. To want to be right, to fight price movement and direction by inserting what we think MUST come true based on certain conditions. Automated programs obviously aren’t humans. They’re designed by humans, but a good developer who has a tested system will let the system trade rather than attempting to “trade the system”. 

Speed & Efficiency

Automated systems can execute trades based on certain inputs faster than many humans can even discern what is happening. In addition, as with self directed trading, you can run an automated program on a dedicated server close to the exchange which should further decrease latency and provide more stability..

Backtesting

I believe when trading discretionarily, you should backtest your ideas and strategies to see if you have a statistical edge. Automated programs are no different, but many sophisticated developers can backtest a multitude of strategies over time using more advanced tools. It is important to backtest a large enough sample of occurrences and to make sure the edge is robust in different types of markets.

Full-Time Operation

Unlike humans who need breaks, food, sleep, and time away from the screens, an automated program can run essentially at all times that the market is open. For the trader that has a full-time job or cannot commit more than an hour or so a day to a screen, an automated program could offer a different way to have exposure in the market. 

Risk Management

An automated program designed without good risk management parameters is worthless, or even dangerous,  in my opinion. What’s the point of taking the human element out of something if it’s going to enter into a large position without a stop-out point? At EdgeClear, our programs have predefined risk management on every trade. While there are always risks like technical failures or market gaps, proper risk management is integral to consistent trading. 

Diversification 

As a discretionary trader, I may be able to manage a handful of reliable setups on any given market. With an automated program, I have the potential to build out hundreds of strategies and potential entry criteria or even just a single contract.

What are some of the downsides of automated trading?

We’re still talking about trading, so even when you execute trades by an algorithm, there are still downsides. This is not a bad thing. It’s a function of the market and if you’ve traded long enough, it’s likely that you’ll understand that drawdowns and risk are part of obtaining consistent trading results.

Technical Failure

As with anything that relies heavily on technology, there can be failure points. Systems can go down, programs can glitch, and unexpected issues can arise. This is where human oversight comes in. For example, at EdgeClear we have two automated programs: EdgeQX and EdgeQX-R. While the automation does its thing, there is a team constantly monitoring the programs to step in should there be an emergency.

Over Optimization

Some developers may have a tendency to “over optimize” their strategy. That is during backtesting, they may like 50% of what they are seeing, but the other 50% of the backtested results don’t look great. These developers may then curve fit—or essentially tweak the parameters of the program so much that the bad results dwindle to almost none and the good results stick around. Sounds good, right? Remember, if it sounds too good to be true, it probably is.

Using the EdgeQX Programs at EdgeClear as an example, these are not curve fitted. The developers behind the program input their ideas to their system and  backtest. If the results do not look good, simply put, the system is probably not worth taking live.  Everything is walked forward based on realistic parameters.

Lack of Human Judgement

Eliminating human elements and having consistency can be positive, but it has its drawbacks. Sometimes market conditions evolve rapidly. So rapidly that an automated program may not have the time or build to adapt quickly.  This can be when you start to experience long drawdowns, or frustrating results as the program that perhaps was working well 6 months ago goes flat or down.

Cost

Developing, backtesting, and deploying your own automated program can be expensive. That can be especially true if you are an individual trader who is looking to deploy your first ever program.

Is An Automated Program Right for You?

If you are interested in exploring an automated futures program to add diversification to your existing portfolio, or simply diversify your own discretionary futures trading, these are the questions I would consider and some common mistakes I’ve seen.

• Does the program have good statistics?
  • What is the Sharpe ratio, if shown?
  • What is the Sortino ratio, if shown?
  • What is its average winning trade?
  • What is its average losing trade?
    
• How long has it been running live, or are you only seeing hypothetical results?
  
• What is its best and worst returns over different time frames?
  
• Do these returns outpace the cost of the program?
  
• Is this program a buy only or sell only program?
  • In my opinion, when looking to allocate money to a futures trading program, you do not want something that is only intended for one side of the market. EdgeQX and EdgeQX-R have the ability to go both long and short. So, even if the overall equities market is in a downtrend, the programs can attempt to capture returns on short opportunities.
    
• Are the results I am being shown inclusive of all fees and costs?
  • For example, our EdgeQX and EdgeQX-R programs display monthly results NET of all costs, commissions, and fees.
    
• How long does the program stay in the market?
  • Does it rely on long hold periods in volatile contracts?
  • Is it a short term/intraday program?
    
• What is its worst drawdown? How long did it last?
  • A common mistake I’ve seen traders make when considering whether or not to allocate money to an automated program is they see the drawdowns as something that is bad, but unlikely to happen again.  In fact, you should expect to see that drawdown again, or perhaps an even worse drawdown in the future.  As with trading discretionarily, trading utilizing automation is not perfect and no system is going to win every trade. I would encourage traders to take a long-term approach when considering whether to allocate capital to an automated program or not, and expect to see another worse drawdown some time in the program’s future. 
    
• Does that worst drawdown make you queasy?
  • If the program had a large and lengthy drawdown that you consider to be out of your realm of comfortability, that program is probably not for you.
    
• Does it sound too good to be true?
  • I would strongly suggest caution when being pitched on a program that has what seems to be extraordinary returns. Especially if you know the market environment at that time was not favorable or should not have offered such opportunities.
    
• What market(s) does it trade? Are they highly volatile or subject to small price movements offering little opportunity?
  
• What is the notional value of what the program is trading? 
  • It’s important to note that different programs will have different suggested capital requirements, but these are usually nothing close to the true Notional traded value of the programs.
  • EdgeClear’s EdgeQX-R ES program, for example, has a suggested starting funding amount of $150,000.  All results displayed in the cut sheets are based on this figure.  However, the program itself can enter into up to 8 Emini SP contracts at a time.  This means the maximum notional value of a trade could be over $2 Million based on the current price of the Emini SP.
    
• Should you try to time when you enter a program?
  • The short answer is no. That is my opinion, but it is rooted in my experience with automated programs in the past. Whether you are interested in a swing system or an intraday program such as EdgeQX or EdgeQX-R, waiting for the “right time” to enter based on either a previous drawdown or all-time-highs for the program can mean missing good trades, or if you’re lucky missing bad trades.  Either way, timing a program is sort of like trying to time buying a dip when you have a long term view of the market.

All futures traders looking to utilize ATS’s should have a clear understanding of their potential and pitfalls. Before investing in a new system, you should ask the right questions, examine the program’s track record. Never settle to lower your comfort level with risk. Deciding to incorporate automation into your trading strategy should align with your goals, risk tolerance, and overall trading preference. Automated trading systems are by no means a one-size-fits-all solution. Finding the right one can bring you closer to your long-term trading goals.

If this has inspired you to consider developing your own automation, or putting money into an existing program, please reach out to our team below!

Derivatives trading involves a substantial risk of loss and is not suitable for all investors.

~ Ian Blanke, Director of Brokerage Services